Investor
appetite for risk has returned strongly in the past two trading days, thanks to
stabilizing interest rates. Not only did U.S. Treasury yields fell further away
from last week’s highs, but even high yield bonds attracted some decent
inflows. Volatility fell to a three-week low, with the VIX Index ending the day
below 16, having declined 68% from its 6 February peak.
Having
been welcomed to office by the steepest correction in more than six years,
equity investors feel that the new Fed Chair, Jerome Powell, will restore confidence. However, the reaction in
currency markets was muted, with the EURUSD and USDJPY trading in narrow ranges
as traders appear to be sitting on the sidelines until Powell provides a new
catalyst.
Powell’s
first semi-annual monetary policy testimony to Congress later today is likely
to be the most significant risk event of the week. The new Fed Chair will
likely downplay the latest market correction and show confidence in
highlighting improvements in the economy, but the markets’ reaction will depend
on how the Fed reacts against such a development.
Investor
focus should be on whether recent inflation and wage growth figures are
starting to become a concern for the central bank. If Powell stated that
faster-than-expected inflation would lead to a more aggressive tightening
policy (suggesting four rate hikes instead of three) in 2018, investors will go
back on the defensive, and risk appetite will be killed. Such a scenario will
see a sharp rally in the U.S. dollar, and a steep selloff in equities and
bonds.
However,
financial markets believe that Powell will not be this transparent regarding
the path of interest rate hikes, and that a gradual policy normalization with
three rate hikes this year is likely to be the base case scenario in today’s
message. There’s likely to be some room
for disappointment here, especially if Powell feels that the Fed is slightly
behind the curve and isn’t overly concerned about investor response.
In
Europe, the focus will return to macro data, with the German preliminary CPI release
likely to show that inflation abated in February. Meanwhile, speeches from the
ECB Governing Council members, Jens
Weidmann and Yves Mersch, will
be of greater importance to the Euro, especially if they provide fresh insights
on the ECB’s monetary policy outlook.
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